Systemic Risk refers to those dangers that threaten the entire financial sector, another segment of the market, or the entire market. Analysts and economists also call this volatility, “undiversifiable” risk, and market risk. Such risk is especially dangerous because it can not be entirely avoided nor accurately predicted or forecast. There is no practical way to mitigate such risks to the entire system by diversifying assets. Instead, it can only be managed (though never perfectly) via effective hedging strategies or through the optimal allocation of assets.
Another way of considering such Systemic Risk is that it entails the very real possibility that a company-level or bank-level failure could set off serious volatility and instability. It might begin a chain reaction that leads to collapse in a whole industry, market segment, or even entire national or multinational economy. This risk to the system caused much of the Global Financial Crisis of 2008. At this tumultuous time in American and Western economic and geopolitical history, there were a number of financial companies in particular that were labeled too big to fail simply because they posed a real risk to the entire system.
This is the case because institutions like these are extremely large and systemically important in their own market industries. In extreme cases they might represent a dangerously large portion of the entire economy of a nation. Firms that are highly entangled with a number of other ones also prove to be systemically risky.
The federal government of the United States engages in the study of systemic risk so that it can justify becoming involved in the national economy from time to time. They do this with the idealism that they can lessen the impacts of company-centered events that cause sometimes severe ripples. The Feds feel with surgically- and precisely-targeted actions or regulations that they can reduce the severity of the consequences of these failures on a macroeconomic level. One example of this was the Dodd-Frank Act of 2010. This massive package of additional rules, regulations, and laws was intended to stop another Global Financial Crisis and Great Recession from happening. The heavy-handed regulation of important banks and other financial companies is supposed to reduce risk to the system.
It is instructive to look at the historical real-world examples of which companies posed such Systemic Risk in the middle of this greatest financial crisis since the Great Depression of the 1930s. It was the so-called “Lehman Brothers moment” that nearly brought down the entire Western-based financial and banking system in 2009. The size and scope of Lehman Brothers and its connectedness to the entire American economy caused it to be a massive source of risk to the system.
As the company collapsed the effect of this spread far and wide through the entire national and even international financial system. In the United States first, the capital markets froze. This meant that companies and individuals were no longer able to access loans. In some cases, they still could obtain them, but only if they had the highest standard of creditworthiness so they would not entail any risk of default for the embattled banks and other lenders.
At the same time, AIG the American International Group insurance company experienced intense and insurmountable financial problems. As the world’s largest insurance company, they were overly connected to the other banks and financial companies of the globe. This made them a serious Systemic Risk not only to the American financial system, but also to the British, European, and Asian financial systems.
Their own portfolio of highly toxic assets connected with subprime mortgages and residential MBS mortgage backed securities meant it suffered from repeated calls for collateral, a downgrade of its credit rating, and an evaporation of liquidity. This only worsened and became a vicious downward spiral as the values of these poisonous assets declined further every month.
For some unknown reason, the same U.S. government that would not prop up Lehman Brothers intervened dramatically to save the AIG by loaning them over $180 billion. It may have been because various regulators, analysts, and economists, were convinced that the failure of AIG would have led to many additional banks, insurance companies, and financial firms collapsing.